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Views from the Inside: Equity is a wonderful incentive

This is for founders, investors and employees who are involved with emerging companies. If you are in that group, you need to act on this in 2013. It could cut your income tax bill dramatically.

The Basics

Equity is a wonderful incentive. Founders get it for their ideas and sweat. Investors get it for capital. Companies use it to attract and retain key employees. Stock options are often the “equity” compensation for employees. Options will vest over time.

Founders and investors who hold their stock for at least a year will be entitled to the 23.8 percent federal capital gains tax rate when they sell. If you received that stock in exchange for services, you will pay income taxes on the value of that stock at the same tax rates as apply wage income (as much as 43 percent). After that, if you hold the stock for at least a year, any further appreciation will qualify for the lower capital gains tax rate.

What is so special about 2013?

In 2013, non-corporate investors, employees and founders in many small U.S. corporations are entitled to a special so-called “Qualified Small Business Stock” tax break. It works like this: If you invest directly in a company when it has less than $50 million of assets (measured by cost, not value of the assets or valuation of the company), you can pay ZERO federal tax on the first $10 million of gain provided that you hold it for at least five years. That’s a savings of almost 24 percent of the gain. Massachusetts has a related tax break. Most early stage companies will qualify for this.